Pentagon sees new risks to industrial base during current spending downturn

Jared Serbu reports.

While the Pentagon and its suppliers have gone through plenty of Defense spending
downturns before, they say this one is different and poses risks the earlier ones
didn't, both for the companies themselves and for future military capabilities.

Military spending has ebbed and flowed on an ongoing basis for most of the
nation's history. But in the past, the cycles have followed a certain logic. The
buildups tended to happen when wars start, and the drawdowns tended to happen once
wars were over.

What makes the current cycle different, DoD and industry officials argue, is the
cuts started long before the end of the war and were the product of political
stalemate, not a policy consensus about national security priorities.

A little more than two years after sequestration's formulaic budget cuts first
took hold, Congress has acted around the margins to add more money to the
government's domestic and Defense budgets, but no one quite knows where things are
headed.

That uncertainty makes the Pentagon worried about the health of the defense
industry, particularly small suppliers, Elana Broitman, the deputy assistant
secretary of Defense for manufacturing and industrial base policy, told a
Bloomberg Government conference on Wednesday,

"The cuts are precipitous, and they aren't tied to any long-term policy
explanations," she said. "That makes it very difficult for us to plan, and it
makes it very difficult for industry to plan. The defense industry is unlike a lot
of other industries in that if a defense company comes up with a new product and
we don't buy it, literally no one else is allowed to buy it. If we can't fund that
research and development and provide that certainty, it's very difficult to see
how we're going to be able to get the best products for our warfighters. The other
thing that's been happening over the last decade is that we can no longer
guarantee that the U.S. product is always the best product. If we aren't investing
in our industries in the way that those countries with more government-owned
industries are able to invest, that's also going to be detrimental."

Further mergers, acquisitions not advised

Another complication compared to past downturns is the defense industry simply
looks a lot different than it did at start of the last spending dip, Broitman
said.

When the Cold War was ending, Defense procurement budgets were falling
dramatically, but DoD had a sufficient abundance of "top tier" vendors. The
department urged them to merge with one another, in order to make the industrial
base more efficient.

They did, and today, the Pentagon doesn't think it's in the government's interest
for its prime contractors to consolidate any further, since mergers and
acquisitions have left only a handful of "heritage" vendors, whose business is
still focused mainly on defense.

"We're very concerned about continuing competition in industry, and it's just a
market truism that competition leads to better quality and better pricing," she
said. "That's something we worry about quite a bit, because it also means there
are going to be fewer entities around to fund some of the innovation that we're
worried about."

Even though the biggest trough in procurement spending under sequestration still
is two fiscal years away, the Pentagon already sees fewer competitors bidding on
its requests for proposals, said Frank Kendall, the undersecretary of Defense for
acquisition, technology and logistics.

That's in spite of the department's Better Buying Power initiative, which has
emphasized the need to increase competition for contracts.

"Competition across the board is the best thing we can do to reduce cost, period.
But our numbers are not up. They're down a little bit," Kendall told the National
Defense Industrial Association's annual logistics forum last week. "I've got to
look deeply into that and figure out what's happening there, but I think part of
what's going on is that the budget cuts and constant changes in plans mean we're
basically doing fewer new things, which is where you're most likely to get
competition. And given the way we treated the government workforce last year, we
were lacking in the basic resources we need to run our competitions."

DoD officials say at least during the short term, sequestration hasn't created a
crisis within its industrial base. The department's biggest contractors' last few
quarterly earnings reports have wowed Wall Street investors.

Earnings are up

Lockheed Martin, the Pentagon's largest single vendor, said Thursday that its
first-quarter profits were 23 percent higher than what the company experienced a
year ago.